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Friday, May 16, 2008

The inside of a VC company or VC 101


Venture capital fund operations

Roles within a VC firm
Venture capital general partners (also known in this case as "venture capitalists" or "VCs") are the executives in the firm, in other words the investment professionals. Typical career backgrounds vary, but broadly speaking VCs come from either an operational or a finance background. VCs with an operational background tend to be former chief executives at firms similar to those which the partnership finances and other senior executives in technology companies. VCs with finance backgrounds come from investment banks, M&A firms, and other firms in the corporate investment and finance space.
Investors in venture capital funds are known as limited partners. This constituency comprises both high net worth individuals and institutions with large amounts of available capital, such as state and private pension funds, university financial endowments, foundations, insurance companies, and pooled investment vehicles, called fund of funds or mutual funds.
Other positions at venture capital firms include venture partners and entrepreneur-in-residence (EIR). Venture partners "bring in deals" and receive income only on deals they work on (as opposed to general partners who receive income on all deals). EIRs are experts in a particular domain and perform due diligence on potential deals. EIRs are engaged by VC firms temporarily (six to 18 months) and are expected to develop and pitch startup ideas to their host firm (although neither party is bound to work with each other). Some EIR's move on to roles such as Chief Technology Officer (CTO) at a portfolio company. According to the National Venture Capital Association the typical individual believes that a venture capitalist is a rich individual ready to invest in a new business venture, an investment into a "change-the-world" idea. On the contrary the investors look for a high interest yielding opportunity.
The "associate" is the typical apprentice within a venture capital firm. After a few successful years, an associate may move up to the "senior associate" position. The next step from senior associate is "principal," typically a partner track position. Alternatively, there are many pre-MBA associate roles that are used solely for the purpose of dealsourcing, and the associate is usually expected to move on after two years.
Venture Capital may be a viable source of financing for a business. While they generally invest in businesses that are more established and ongoing, some do fund start-ups. In general they tend to invest in high-technology businesses such as research and development, electronics and computers. Venture Capitalists deal more in large sums of money, numbering into the millions of dollars, so they are generally well suited to businesses that are going grand from the start or have grown and require gigantic expansion.

Structure of the funds
Most venture capital funds have a fixed life of 10 years, with the possibility of a few years of extensions to allow for private companies still seeking liquidity. The investing cycle for most funds is generally three to five years, after which the focus is managing and making follow-on investments in an existing portfolio. This model was pioneered by successful funds in Silicon Valley through the 1980s to invest in technological trends broadly but only during their period of ascendance, and to cut exposure to management and marketing risks of any individual firm or its product.
In such a fund, the investors have a fixed commitment to the fund that is "called down" by the VCs over time as the fund makes its investments. There are substantial penalties for a Limited Partner (or investor) that fails to participate in a capital call.

Venture Capital Investing
As discussed in Private Equity Funds: Business Structure and Operations, venture capital investing involves the provision of capital to business enterprises in the early stages of the development of new products or services. Venture capital investing was especially prominent throughout the 1990s, with the boom and the subsequent collapse of speculative interest in computer and information technology, Internet and communications sectors.[6]

Compensation
In a typical venture capital fund, the general partners receive an annual management fee equal to 2% of the committed capital to the fund and 20% of the net profits (also known as "carried interest") of the fund; a so-called "two and 20" arrangement, comparable to the compensation arrangements for many hedge funds. Strong Limited Partner interest in top-tier venture firms has led to a general trend toward terms more favorable to the venture partnership, and many groups now have carried interest of 25-30% on their funds. Because a fund may run out of capital prior to the end of its life, larger VCs usually have several overlapping funds at the same time; this lets the larger firm keep specialists in all stages of the development of firms almost constantly engaged. Smaller firms tend to thrive or fail with their initial industry contacts; by the time the fund cashes out, an entirely-new generation of technologies and people is ascending, whom the general partners may not know well, and so it is prudent to reassess and shift industries or personnel rather than attempt to simply invest more in the industry or people the partners already know.
GW

1 comment:

Anthony Kuhn said...

Gordon:

I liked your VC primer enough to give it a link today in my blog post for the Innovators-Network. I especially like the compensation structure, which is good knowledge for startups to have so they can better understand the equity bargaining process.